At the end of last week, I profiled Warren Buffett (Trades, Portfolio)'s interest in airline stocks, most notably Delta Airlines (DAL, Financial). Since then, the outlook for airlines has only deteriorated.
It has become bad enough that most airlines are taking aggressive action to mitigate costs. Analysts are also starting to question if these businesses can survive the coronavirus outbreak, which could last for more than a year, or if we will see airlines begin to go bankrupt due to lack of income and high debt.
Delta reacts
Delta has reacted to the outbreak by slashing flights. The carrier is reducing international flight capacity, which produces about one fourth of its overall revenue, by 20% to 25%. Delta's routes over the Pacific to Asia, where the virus originated, will be cut by 65%.
The carrier is also planning to reduce domestic capacity in the U.S. by 10% to 15%, primarily through a reduction in the frequency of flights rather than elimination of routes. Delta expects its airplanes to be only 65% to 70% full this month.
The airline is also taking other actions to reduce costs. These include a company-wide hiring freeze and offering voluntary leave to employees. It is also grounding some aircraft completely.
Delta expects these measures will save $1.8 billion. On top of management's efforts to reduce overall costs, the company also plans to save around $2 billion this year from lower fuel costs.
Additionally, management believes the company can achieve another $3 billion in cost savings by deferring capital spending, pension contributions and share repurchases.
Can Delta survive?
At this stage, is it difficult to tell if these efforts will help the company weather the storm. It is also impossible to determine how long the economic uncertainty will last. If the significant disruption lasts for more than a couple of quarters, Delta, as well as other carriers, might have to take further cost reduction action.
However, does this mean Delta could go bankrupt? I think it is unlikely. Delta and its U.S. peers operate in a relatively consolidated market. Moreover, air travel is unlikely to suffer significantly over the long term. Unless the Federal Government rapidly builds a massive high-speed rail construction program, air travel will remain the fastest and most convenient way to zip around the United States for the foreseeable future.
Invert the problem
Inverting the problem, what's the most significant risk to Delta's survival? A sustained drop in passenger revenue will undoubtedly hurt the business. A complete travel ban would be even more painful.
In this scenario, the company would have to ground all of its planes. That would lead to a significant reduction in costs, but the group would still have to spend on maintenance and finance costs. Is the balance sheet strong enough to enable the company to survive this sort of environment?
It would appear that the company most likely has enough financial headroom. Its own figures put liquidity at $5 billion at the end of the March 2019 quarter. On top of this, Delta has approximately $20 billion worth of unencumbered assets, including $12 billion in aircraft.
The company's interest costs were $300 million for the whole of 2019. Aircraft leases and other rentals amounted to $2.2 billion, including landing fees.
These numbers suggest that the company has plenty of liquidity to cover basic leasing and interest costs for at least 12 months if everything else is cut to zero. That would be the worst-case scenario, in my opinion, as coronavirus fears are not likely to restrict global travel for longer than that.
While we don't know what the future holds for the global economy, or the ultimate impact the virus outbreak will have on businesses around the world, these estimates suggest that the risk of a total capital impairment for Delta is low. It seems Buffett believes this to be true as well.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Could Warren Buffett Be Considering Buying Energy Stocks?
- Warren Buffett: Why GEICO Outperformed in 2009
- Warren Buffett and Seth Klarman: Ignore Book Value Cost
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